Saturday, October 25, 2008

The Drunk and the Ditch

These are parts of my email correspondence with a friend on my post about the crisis, only lightly edited...

A said:

That's not exactly true. Neither mortgages nor MBS have been the real problem of the current situation. Google CDO and CDS, especially the last one. In fact, that could happen with any other risky oversecuritized asset such as credit cards, auto loans, etc. This time it just happen to be mortgages. Next time it could me something else. As far back as 2003, Buffett had warned that the complex securities at the center of today's troubles — once so profitable, but now toxic — were "financial weapons of mass destruction." I'd say greed and shortsightedness are the main reason. Can't blame them though...

Nobody said:

This is what Buffet is actually saying:

Charlie Rose:I'm interested in this because people are asking, did people get away with murder here? Were there people who simply gained the system and took advantage and made huge amounts of profit, and we had accesses that inevitably led to where we are today?

Warren Buffett:Well, we had all of that. But I would say the biggest single cause was we had an incredible residential real estate bubble. I mean you can go back to tulip bulbs in Holland 400 years ago. The human beings going through combinations of fear and greed and all of that sort of thing, their behavior can lead to bubbles. And it may have had and Internet bubble at one time, you've had a farm bubble, farmland bubble in the Midwest which resulted in all kinds of tragedy in the early '80s. But 300 million Americans, their lending institutions, their government, their media, all believed that house prices were going to go up consistently. And that got billed into a $20 trillion residential home market. Lending was done based on it, and everybody did a lot of foolish things. And people really behaved in a fraudulent way or something, we'll go back and find the culprits later on. But that really isn't the problem we have. I mean that's where it came from, though. We leveraged up and if you have a 20 percent fall in value of a $20 trillion asset, that's $4 trillion. And when $4 trillion lands -- losses land in the wrong part of this economy, it can gum up the whole place.

A said:

Exactly. Note the last two lines.

Nobody said:

Well. He is saying that the biggest single cause of the current mess is the housing bubble created by expectations that the prices would continue go up. And these expectations got billed into a 20 trillion worth residential estate market. When such a market goes down by 20%, the damage spreads to other parts of the economy and can send the whole economy into coma.

Banks and others should have known better of course. Nobody absolves them from responsibility. But how it excuses the regulation or makes the trillions accumulated by Fannie and Freddie in outstanding bonds irrelevant to the current crisis? I don't understand this.

The regulators inflated the market through Freddie and Fannie, then interest rates were lowered and kept negative in real terms for years. There was a lot of cheap money that had to find use for itself. This is how the situation was created with all this money chasing mortgages on the most inflated market that was already spiraling out of control. It's a simple supply and demand thing aggravated by the fact that Freddie and Fannie had already sucked trillions worth mortgages off the market.

In this situation the pressure on loan originators was growing to generate new loans and this is what they were doing. The quality of loans was deteriorating since all normal loans that could be issued had been issued already while the market had been already massively overpriced.

No argument that the Wall Street managed to spread this mess to all corners of the US and the whole world actually. But the thing remains that the negative interest rates, regulation and Freddie and Fannie were responsibility of the government.

You should also not overlook the fact that government sponsored ventures enjoy an implicit government subsidy. The same two Fs were reselling mortgages with profit as the buyers of their bonds considered their stuff safe and were ready to pay more for it. But even more important, the presence and trillions worth activities of these two constituted an implicit subsidy to the whole market and helped unleash the speculation. The expectation that the prices would go up could only be boosted by the fact that the government was intervening in the market with the most ambitious program of expanding home ownership in the American history.

Maybe with the passage of time the initial impetus given to the market by the regulators was dwarfed by the scale of speculation. But the fact remains that it was the regulation that led to overblown expectations and breakdown of self discipline among private players on the market.

A said:

Dude, a drunk on his way home slips into a ditch and breaks his head. What is the real cause for the broken head: the ditch or the drunkenness?

Nobody said:

Using your drunk man's parable, the drunk is responsible for his drunkenness of course but this does not excuse the drunkenness of those who dug the ditch. In particular, given that in their drunkenness they dug the ditch wide enough and all the way to the doorsteps of the drunk man's house hoping that this is how they are helping him to get home without getting lost on the way.

Now the drunk has to be bailed out of the ditch and the ditch is wrecked and the man is still way far from his home. Other drunks curse the drunk and decide that they need to continue digging ditches, but they should better surround them with fences to prevent the drunk from slipping into one of them again.

But the drunk is no longer drunk, he woke up and is cursing his drunkenness and promising never drink again, neither CDS nor CDO, never walk into the night and keep a mile long distance from any ditch and trench. In fact, so vigorously the drunk has set out about de-leveraging himself out of the ditch that the whole credit system seized up as the drunk suspended lending while he is selling off his financial and other assets.

But the other drunks don't let up. So they are planning even more ditches to steer the drunk safely to his home, while fortifying their trenches with massive fences.

The lesson of the story is that one should sober oneself first and second stop digging trenches. Then there would be no need to cover them with fences, and even worry if the drunk is drunk again in the first place.

The story has a bizarre ending. On waking up the other drinks will soon discover that they were digging the trench in the wrong direction. That person has never lived in that home at all. It was another man's house !!! With 70% or 75% home ownership the US is way ahead of the rest of the world on this. How much is enough? 80%? 90%? Does everybody need to be a home owner? In the midst of their drunkenness the other drunks have forgot to ask themselves these questions.

Anyway, my post was in no way intended as apologetics of the Wall Street. What I was saying is that there is a society wide breakdown of common sense and attitudes affecting all, including the electorate, the regulators and the Wall Street. Unless you are going to say that the regulators were ok, we are in agreement.

A said:

Dude, you are obviously pushing the metaphor too far. All I wanted to say is not that ditches in your backyard are not important, but rather that given the severe alcoholism of the current financial system we have far bigger problems to be concerned about.

And I wouldn't call it breakdown. To me it all actually makes perfect sense. People had an opportunity to make a lot of money. And they did. Seems pretty sound thing to do. I would actually be very surprised if they do otherwise. It's like you blame a 5-year old for swallowing a bottle of pills. Blame those who didn't put a prevention mechanism into the bottle cap in the first place. And by the bottle I mean the financial markets with such artificial instruments as CDO and CDS and not the infamous subprime mortgage practice which is just a mere by-product of the above.

As to the regulation ( or lack of thereof ), the prevailing theory across the economists has been the idea of market self-regulation ( "the invisible hand" ) which postulates that the less the government intervenes in the markets ( including the financial one ), the better those markets work. Now, unless you have the competence ( and balls ) to challenge Melton Friedman yourself, let's leave it to the professionals to argue whether this theory stands in the long run.